Humble Attempt to Trumpet a Misjudgment

"It's a good habit to trumpet your failures and be quiet about your successes."Â –Â Charlie Munger (Trades, Portfolio)

Â

"Experience is what you get when you didn't get what you wanted, and experience is often the most valuable thing you have to offer.” – Randy Pausch, "The Last Lecture"

Â

Above are two of my favorite quotes because they remind me of staying humble no matter how much progress I have made in my value investing journey. Reflecting back on what I have written, I realized the paucity of articles dedicated to trumpet my failures or investments that went much worse than I had expected. Certainly this lack of failure trumpeting articles is not due to my lack of failures.

One thing I found comforting is that since I was able to add a few items on my personal investment checklist, over time the frequency and magnitude of my mistakes have become more manageable and bearable as I am more aware of my blind spots. But there are still plenty of investments I have made that went far worse than I had expected. Fortunately, I have detailed my thinking and analysis in my journal along the way. In this article I’d like to share one such example and the lessons I have learned.

How Colfax got my attention

It was in October 2014 that I set my attention on an industrial company that I thought was on the way to potentially become the next Danaher (DHR, Financial). This company is Colfax Corp. (CFX, Financial). Colfax is a leading welding equipment and consumables, gas handling and fluid handling manufacturer.

Colfax serves a variety of industrial, power, energy and infrastructure end markets. It was founded in 1995 by the Rales brothers as a vehicle to bring the highly successful management tools of the Danaher Business System (DBS) to the fragmented industrial pump and positioning market. Danaher’s success formula can be summarized as the following four points:

1. Continually improve the cash flow generated from your own existing assets.
2. Deploy cash flows into intelligent acquisitions.
3. Continually improve the cash flow generated from acquired entities.
4. Repeat, repeat, and repeat.

The Colfax Business System (CBS) is basically the same as the Danaher Business System and most of Colfax’s senior executives such as the then-CEO Steve Simms were ex-Danaher. Therefore, it seems that Colfax has the potential to become a Danaherlike business.

There were two particularly powerful biases working against me back then (October 2014):

1. The stock price had just dropped from over $70 a share to $50 a share. GAAP net income for 2013 was $1.56 per share, but my calculated owner’s earning per share was about $2.65 per share. So Colfax valuation went from more than 26 times owners’ earnings to almost 19 times owners’ earnings. The drop in price triggered a contrast bias.
2. Liking and mere association bias – Colfax was owned by a few great value investors that I admire back then including Chuck Akre (Trades, Portfolio), Tom Gayner (Trades, Portfolio) and Brian Bares. A few other well respected funds also owns the shares in Colfax such as Tiger Global, Blue Ridge and BDT Capital Partners. According to my notes, Akre added some when the stock was in the $60s and $70s.

What’s also interesting was that Colfax had a transformational deal at the beginning of 2012 with the acquisition of Charter International. Charter had been struggling with the competitive post-recessionary environment; it had seen falling margins and rising working capital levels. With the acquisition of Charter, Colfax leaped from a $700 million revenue firm to nearly $4 billion. With the Charter acquisition, I thought Colfax could leverage CBS on a much larger scale and improve Charter’s businesses efficiency and margins, which would have a meaningful impact on Colfax’s business.

Colfax is much better managed than most of its competitors such as Illinois Tool Works (ITW, Financial), Flowserve Corp. (FLS, Financial) and Xylem Inc. (XYL, Financial) besides Lincoln Electric Holdings (LECO, Financial). Critical to Colfax’s value proposition is that Colfax’s competitors do not all have lean cultures as well – if so substantially all of their efforts would be passed along to the customer in lower price or higher service. Given how fragmented Colfax’s end markets are and the level of cultural commitment needed to really apply a lean process, I feel comfortable that the overwhelming majority of peers are not practicing anything resembling CBS culture, and Colfax stands to benefit from its internal improvements.

Why I thought the stock was cheap

In assessing why the stock was cheap in October 2014, I came up with the following:

After a near-perfect 2013, Colfax headed straight into execution challenges in 2014. What’s more is that each quarter seemed to bring new headwinds affecting the business. These issues were:

1) An attempt at complicated, large fluid pump.

2) Softness in end markets, particularly O&G, power-gen, mining and Europe.

3) ESAB plant issues.

4) Perception issues with percentage completion projects at Howden.

5) Acquisition is hard to model.

6) Significant foreign exchange headwinds.

7) There were a lot of noises in reported financials.

Dealing with psychological biases

My conclusion was the market was overreacting to a collection of short-term problems. But I was also aware of the powerful psychological biases. In an attempt to straighten out my biases, I wrote the following in October 2014:

In the assessment of Colfax I am greatly exposed to two tendencies, which could make me less rational than I thought I was.

1. Liking/disliking tendency – reminder: what Munger said about this tendency.

“One very practical consequence of the liking/loving tendency is that it acts as a conditioning device that makes the liker or lover tend:

• To ignore faults of, and comply with wishes of, the object of his affection.
• To favor people, products, and actions mere associated with the object of his affection.
• To distort other facts to facilitate love."

Applying this to my analysis of Colfax, I admire Chuck Akre, the Rales Brothers and Steven Simms, I may naturally have a favorable view of the company associated with them.

2. Mere association tendency – again, it is worthwhile revisiting what Munger has taught us:

“Some of the most important miscalculations come from what is accidentally associated with one’s past success or one’s liking and loving or one’s disliking and hating, which includes a natural hatred for bad news.

To avoid being misled by the mere association of some fact with past success, use this memory clue. Think of Napoleon and Hitler when they invaded Russia after using their armies with much success elsewhere. And there are plenty of mundane examples of results like those of Napoleon and Hitler

I know the Rales Brothers and Steven Simms have achieved fabulous results at Danaher and when I think of Colfax, I can’t help but associate Colfax with Danaher; I am naturally inclined to assume Colfax will be another successful story just from mere association of Danaher’s admirable track record. In order to remain rational, I need to turn to the antidotes Munger subscribed:

1. To carefully examine each past success, looking for accidental, no causative factors associated with such success that will tend to mislead as one appraises odds implicit in a proposed new undertaking.
2. To look for dangerous aspects of the new undertaking that was not persistent when past success occurred.”

In terms of antidote No. 1, I don’t know for sure whether the success of Danaher is accidental or not, but I can’t disapprove it as a lucky endeavor either. From what I have read and observed, the success that the Rales brothers achieved at Danaher is well deserved. They had the right philosophy, the right system and the right discipline.

Now turn to antidote No. 2, Colfax differs from Danaher in that Colfax is the in global industrial and engineering business whereas Danaher was more like a manufacturing and instruments business when the Rales brother took the reins in the mid-1980s. Although CBS and DBS are essentially the same system, the incremental return on capital generated through the application of the system is likely to be different given different economic characteristics of the businesses Colfax and Danaher operate in. To get comfortable with this, I looked at the operating margins and net margins of Colfax and compare them to those of Danaher in Danaher’s early years, I observed that the margins are not that different but Colfax’s current ROIC is much lower than that of Danaher’s in its early days.

Danaher was riding the emerging market growth wave (especially China) and Colfax is facing a different world (slow EU growth, China Growth).

What went worse than expected?

My biggest misjudgment was where Colfax was in the cycle in some of the end markets. After the acquisition of Charter, I got excited that Colfax can finally put CBS use on a large scale so that significant operational improvement was imminent. That led me to underweight the disconfirming evidence that the cycle in the end markets is turning. I had identified the softness in some of Colfax’s end market but didn’t think it was going to last long. I also knew Colfax was facing significant currency headwind as a large portion of Colfax’s revenue comes from emerging markets.

I started a position in Colfax when the stock was between $45 to $50. Mitch Rales had some large insider buy at those level too.

It turned out that the industry went straight into a recession that wouldn’t bottom out until more than a year later and foreign exchange became a brutal drag on earnings.

The stock went from $47 to $37 to $27 and then finally bottomed out at $18 early in 2016. I added to the position all the way down and the last add was at $20. My average cost was about $30 per share.

Checklist items added

Are the end markets in which the company sells its products and services experiencing softness? If so, collecting information to assess whether the cycle was about to turn sharply down? What are competitors and industry leaders seeing in terms of the market condition across the globe?

Summary lesson

In short, I got the business quality right, but I was too excited about jumping on the Colfax wagon while ignoring the end market danger signs. I don’t think it was a disaster to initiate a position for Colfax at $47, but my average cost could have been a lot lower had I been paying more attention to what was going on in Colfax’s end markets.

Disclosure: Long Colfax.

Start a free seven-day trial of Premium Membership to GuruFocus.